How to repair the global recovery in 5 easy steps

Confidence in the global recovery is at a crossroads and the uncertainty about the road ahead has clearly fed through to financial markets in recent weeks.

Much of the blame for the recent downturn in sentiment lies at the euro zone’s door where renewed risks of recession, deflation and the deepening of a supposedly cured debt crisis loom large. 

But it will take a global effort to stop the rot. Five simple steps can easily mend the process of recovery. But it will take determination, flair and resolute action to put them into play.

1. The euro zone must adopt full-blown QE. Another shot of monetary stimulus is urgently needed. The European Central Bank’s recent decision to buy asset backed securities (ABS) in the hope of sparking a bank lending spree to jump-start faster recovery looks far too tame. ECB President Mario Draghi has hinted the ABS buying programme could be stretched to 1 trillion euros, but an asset purchase programme at least three to four times that size is needed to deliver a turnaround like that seen in the US and UK economies. Unfortunately, the German government and the Bundesbank still stand in the way. For them, full-blown QE remains a domestic political taboo, but Germany must embrace its responsibilities as a world economic leader – prioritising its commitment to a stronger, united Europe, instead of being side-tracked by myopic domestic issues. The survival of the single currency is at stake.

2. The euro zone should suspend the Fiscal Stability Pact. Vigorous Keynesian fiscal reflation is the second pre-requisite for recovery. Inadequate ECB monetary easing efforts so far have been badly blunted by intense political pressure on euro zone governments to balance their budgets and cut debt. Austerity cuts have deprived the recovery of vital stimulus and left unemployment at record highs around the region. A number of countries, including France and Italy, have ditched debt reduction and made stronger growth their top priority. This leaves Germany increasingly isolated on its prescription for an economic revival based on a balanced budget and no new debt issuance. The Fiscal Stability Pact should only resume when the euro zone is back to full employment and sustainable growth. That could be many years away.

3. A weaker euro is crucial for an export led recovery. The euro’s 10 per cent fall since May has given euro zone exporters a much needed competitive boost, but the windfall would have been much better if policymakers had actively encouraged the euro to weaken even more. The euro probably needs to drop a further 10-15 per cent before stronger export demand begins to have a more positive impact on euro zone growth prospects. A weaker euro would also raise import costs and act as a further foil against deflation.

4. The US and the UK must hold their fire on monetary tightening. There is no need to rush into raising interest rates or to unwind their QE asset stockpiles, particularly while the outlook for global recovery looks uncertain and low inflation continues to loom over the US and UK. The US Federal Reserve and the Bank of England would both be better advised to keep their policy powder dry should global economic conditions take a turn for the worse.

5. China must maintain a bias towards more easing. With China’s growth rate slowing to 7.3 per cent in the third quarter, the economy risks missing its official annual GDP target – 7.5 per cent for 2014 - for the first time in 15 years. China’s authorities could definitely lend a hand with easier monetary policy to boost domestic demand, increasing the economy’s appetite for imported goods and services at the same time. It would be a positive step in the government’s quest to reshape the economy towards more domestic consumption. But China would also win greater plaudits for making a stronger contribution to global recovery.

This is a moment of opportunity for global policy makers to turn things around. If they fail and the world economy and financial markets dive, they only have themselves to blame.

Reprinted courtesy of South China Morning Post  27 October 2014

RBA risks confusing markets with mixed economic signals

The Reserve Bank of Australia seems to have lost its policy bearings.

No wonder given the mixed signals it is getting from data and developments inside its own economy, let alone that of the rest of the world.

Unreliable jobs data at home, a persistent housing bubble, a slowdown in China, weakening commodity prices, a very patchy recovery in G7 economies and anaemic world trade growth is not a helpful backdrop to policy making.

Especially for a central bank that is all too keenly aware of the latest warnings from the International Monetary Fund that record low interest rates in the world's major central banks are fuelling excessive risk taking behaviour.

The RBA has been laying the groundwork for a hike from its record low cash rate of 2.5 per cent for quite some time, wanting to steer policy back to better equilibrium with economic growth that has been in a strong upward cycle for several years thanks to the boom in the resources and mining sectors.

The markets have definitely taken the hint - forecasters generally expect higher borrowing costs to kick in around Q1.

The problem for the RBA is that the commodity boom has begun to cool - far more quickly than had been expected - while the spillover effects to the domestic economy, particularly in property prices, are still building steadily.

Hopes for stronger global economic revival have caught a bad chill. 

The Australian dollar - typically a very good gauge of global economic sentiment and risk appetite – has lost its mojo. 

But it is not just worries about slower world trade, weaker commodity prices and falling stock markets that have dented the Australian dollar in recent weeks. Currency markets may be awaking to the possibility that higher Aussie interest rates is not the safe one-way bet that it is supposed to be.

The downturn in global economic prospects opens up a new thread in the interest rate debate. Australia’s record low official cash rate might not only end up stuck at 2.5 percent for a lot longer than previously thought. But, in a worst case scenario, another RBA rate cut could be in the offing if the global downturn suddenly takes a turn for the worse.

That's bad news for investors paying closer attention to recent IMF warnings about over-easy G7 monetary policies leading to excessive risk-taking and credit expansion – possibly sowing the seeds for another financial meltdown in the process.

But the prospect of slower growth in China has a direct bearing on Australia’s growth outlook and on the RBA’s interest rate considerations too – not least because over 35 per cent of Australia’s exports go to China. If China suffers anything close to a bumpy landing, Australia would feel fall-out in a major way, forcing the RBA’s hand into easier policy.

This makes it much harder for the RBA to find its true bearings and get rates headed in the right direction over the coming months. The RBA needs to find the right balance between rising external risks while meeting domestic needs at the same time. This is being made doubly difficult by some of the mixed messages coming out from the Australian economy right now.

Australia’s housing boom continues to be a thorn in the RBA’s side. House price inflation in metropolitan areas is running close to 10% and recently as high as 14.3% in Sydney. Ultra-low borrowing costs are clearly feeding the speculative frenzy, but the RBA has recently intimated that lending controls might be the better option than using the spike of higher rates to pop the bubble.

Employment conditions are sending oblique signals on rates as well. Where labour market data may be providing clearer policy signals for central banks like the US Fed and the Bank of England, in Australia, recent employment trends have been just plain confusing, thanks to hefty back revisions in the jobs numbers.

It is leaving the markets with a sense that the RBA is ‘flying blind’ on rates for the time being. October’s policy statement reaffirmed the RBA’s commitment to keeping ‘a period of stability in interest rates’.

But the RBA needs to be very careful about the message that it is relaying on stable rates, especially while dropping hints that the Australian dollar ‘remains high by high by historical standards’. Aussie dollar bears will soon start to scent blood.

If global economic conditions take a further dive and the RBA starts to wobble the Australian dollar will soon start to tumble.

Reprinted courtesy of South China Morning Post  13 October 2014

The euro is a broken currency and possibly beyond repair

The euro’s survival hangs in the balance as worries about weakening fundamentals that have dogged private sector investors since the onset of the global financial crisis are now spreading to reserve managers at official sovereign institutions.

The European Central Bank is hardly helping matters. Repeated policy failure has seen the bets stack up that the euro will fall to re-test parity with the US dollar in the near future.

The risk is that the combination of weak euro fundamentals and the dollar’s correction from its massively oversold position could take the rate a lot lower.

Dollar bulls are on a stampede and the euro/dollar exchange rate could easily get trampled down to 2000’s US$0.8228 low. Historical precedents do not end there.

Back in the 1980s, when the dollar was at the peak of its super-strong cycle, the ‘synthetic’ euro was low as US$0.5698. That implies a halving in value for the euro in a worst case scenario.

Right now, the fundamentals are clearly stacking up against the euro – relative growth, inflation, interest rate and bond yield differentials all undermine confidence in the currency.

The euro zone is being sucked into a downward spiral of recession, deflation and deeper debt. A third recession in less than five years seems on the cards. Headline inflation has sunk to 0.3 per cent - a whisker away from negative territory. Employment prospects remain grim. The euro zone jobless rate is stuck near to its 12 per cent record high.

By comparison, the US is notching up 4 per cent-plus growth, inflation is almost back to the Federal Reserve’s 2 per cent target and new hiring is surging. The juxtaposition of US unemployment sinking to a six year low of 5.9 per cent in the October employment report is not lost on the markets. The dollar surged 1-1/4 per cent against the euro in the wake of Friday’s US payrolls report.

Diverging interest rate and bond yield differences could pile a lot more misery on the euro in the coming months.

While the euro zone could be stuck with negative interest rates for years, the Fed is preparing the markets for rate hikes. The job of ‘normalising’ Fed monetary policy could easily take US official rates back to 3-4 per cent in the next two years.

With 10-year US Treasuries now yielding 150 basis points over euro zone government bonds, it lessens the euro’s appeal even further.

Euro zone policymakers are in disarray. They are hitting the panic button on fiscal and monetary stimulus in a last ditch attempt to bolster growth and jobs – and rescue monetary union in the process. But by doing so, they founding policy icons of currency union are being systematically pulled down. Markets are not impressed by what they see.

Fiscal consolidation has been put on the back burner. France has abandoned any attempt to reel in its budget deficit. Other countries look set to follow. Deficits and government debt across the euro zone look set to mushroom.

The weakest link is the ECB. Markets now see it as a lame-duck policymaker. The delay in launching full-blown QE was largely because of opposition from Germany’s Bundesbank.  The rift does not impress the markets. 

Data shows that speculative positions are starting to build against the euro. Investors are switching from US dollars to the euro as the best funding currency to finance carry trades in emerging markets – especially with ECB rates set at zero for quite some time.

But the bigger risk is that central banks are losing faith in the euro as a reserve asset. International Monetary Fund data shows that since the financial crisis the euro’s share of global central bank reserves has slipped to 24 per cent from a peak of 28 per cent. 

If reserve managers abandon the euro, the outflow could quickly turn into a tidal wave. In that scenario, the target of parity for the euro against the dollar would get very quickly submerged.

Reprinted courtesy of South China Morning Post